The Unmitigatable Capital Allocation represents the capital necessary to hold against operational and market risk that exist no matter who your borrower is. Operational and market risk capital is a function of the bank’s gross operating income and total average assets. It is expressed as a percentage of total assets and for most banks is typically less than 2%. PrecisionLender defaults to a value of 1%, which in our experience is a reasonable placeholder. Most PrecisionLender customers utilize the default value.
The Absolute Minimum Capital allocation only kicks in when the calculated total economic capital (i.e. credit capital based on risk grade, loss given default and duration plus the unmitigatable capital) allocation falls below this absolute minimum. As such, it primarily impacts your best credits since the calculated economic capital allocation for your average and weaker credits will almost always exceed the absolute minimum. That is, the lower the Absolute Minimum Capital the more aggressive you can price the best credits at a given ROE target and vice versa. Generally we see the Absolute Minimum Capital allocation in the 6%-8% range, and the PrecisionLender default is at the mid-point of 7%.
One additional consideration when setting the Absolute Minimum pertains to regulatory capital requirements. Regulatory capital, while different from economic capital, acts as a constraint on economic capital. For example, from a regulatory standpoint you may be targeting 8% for an overall capital level at the “portfolio” level in order to satisfy the regulators. However, because loan pricing is done “at the margin” comparing the relative profitability and returns of one loan vs. another, you will have some loans that have less than 8% capital and some that have more. The Absolute Minimum Capital acts as a bridge between economic and regulatory capital by never letting economic capital diverge too far from the regulatory requirement.